moneyFYI
Financial Freedom Is Merely Organized Common Sense
Investment Risk Is Not Like The Others
Investment risk is a multi-factor risk. Unlike single factor risks, you cannot insure multi-factor risks. To lose there must be a market price lower than your cost AND you must need the money now. If you don’t need the money, no loss. Except your emotions won’t let you play that game.
In investing, risk means variability
In particular it’s the amount a security changes over 12 months. Highly unpredictable is “risky” while predictable is not. A security that has produced annual yields between -10% and +20% in its history is highly variable and therefore risky. A security that loses exactly 5% each year is not risky because it is predictable.
Really!
Risk Reward
The theory is based on a vast trove of statistical information. The analysis is elegant and internally consistent. It deals with economic models that try to explain the stock market in a general way. Nonetheless, you can easily fall into a trap.
Risk looks manageable.
People intuitively assume accepting more risk leads to increasing yield. This is an idea about risk management that does not translate into the real world very well. The theory is about the market as a whole. An average result. Some big wins, some big losses, a lot of average returns. For a particular individual taking on more variability might yield more return.
The real world risk is you are not that particular individual.
Reality
Risk taking implies the possibility of loss. If it did not, “risk taking” could be replaced by “sure thing taking”
More risk does not necessarily mean more reward and certainly not for everyone.
Variability and Risk
Why does year over year variability equate to risk? It does not. It is just a convenient way to deal with a complex data set.
I suppose if you need the money at the end of the year it would make sense, but most people don’t invest with a precise date of use and almost none invest with the idea of using all the money at the date. No one retires at 65 and spends all their money the same day. The two factor risk is the market is down and you need the money. All of it.
Market statistics and the “normal” distribution.
The investment risk idea and all the numbers and terms that fall out of that rely on stock market returns being normally distributed. A “normal distribution” is the familiar bell curve, and it presupposes two conditions not met in the stock market.
- the observations are random.
- The observations are independent of each other
Stock returns, say day-to-day, are not independent. It takes time for information to propagate. What happened yesterday affects today and as the word spreads likely will ripple through several weeks. Even months.
They are not random either. If we lay out returns of a certain size we find most cluster near the middle of the curve. Around the average. You will find the stock market returns are too narrow to be “normal”. They are a pinched bell curve. The very extremes, both high and low, show more counts than ones between there and the pinched center. Kurtosis. That demonstrates that stock markets are made up of more variables than the underlying value of businesses on a given day. The lump of returns at the high end is a surrogate for Greed and the ones at the loss end are a surrogate for Fear. There sre more counts there because people accentuate returns then. More trading and more trend supporting results.
The whole idea though is elegantly developed and internally consistent. Just incomplete
We are all subject to greed and fear
We don’t make especially good decisions when caught up in either. Only the skilled should go far afield alone. Most of us will benefit from having another person who understands us and our purposes and who can keep the market in perspective. Some kind of confidante who keeps us on course over the long term.
Despite the incompleteness, we are wise to consider using some of the techniques to manage our portfolios.
Diversification increases predictability
Fear and greed are suppressed when we diversify. Diversification is the idea that not all securities in all markets fall at the same time. Many eggs spread among many baskets. When our portfolio is balanced, we tend to get the emotional trigger less frequently and weaker.
Diversification is about managing your response to your investments, more than about the investments themselves. As a process, it soothes. It also minimizes the effect of your general lack of knowledge and skill regarding investment.
If your tolerance for paper losses is low, then avoidance is value. Diversification helps. There is a cost though. You will miss some of the good stuff.
How do you diversify?
The idea of diversification is to mix assets so the expected return for the portfolio is in a narrower range. Selecting the assets to mix requires they not be “correlated.” Correlated means having a relationship in which one thing moves like or unlike another.
For example. Steel and auto manufacturing are positively correlated. Having both in the portfolio is about the same as having only one. Having a mortgage lender in the portfolio is negatively correlated with a real estate brokerage firm. As there are more foreclosures the lender loses but the broker has more listings.
There is a way to describe them using a single number. The correlation co-efficient. Plus 1 means perfectly positively correlated. If A is up so is B and proportionally the same. Minus 1 is perfectly negatively correlated. If A is up B is down and vice versa. Zero is no correlation, a random relationship. There are many points between, too. A could be a little positively correlated with B maybe correlation of +0.5.
The idea is to build a portfolio that minimizes your exposure to a huge overall negative. Be aware though the idea works in normal times. In times of crisis everything tends to move the same way. Manage other ways then.
Diversification is not easy.
When things are hard, people guess.
They guess to often. There is sound support for the idea that nine well chosen securities will provide adequate diversification. Suppose in the interest of diversification you own a hundred small positions. Is that really diversification? Likely not. It is more commonly called deworsification.
Diversification does not produce yield.
It merely manages your emotions so when you look too often, you don’t trigger an emotion that will hurt long term results.
Carefully selected investments in businesses produce yield. If your portfolio has a hundred positions, there is a high probability that some of your portfolio will be duds you bought long ago and some you bought without thoughtful business consideration. The more stock you buy, the greater is the likelihood you will pick a loser.
It’s all about you
We are emotional beings. The rule of life is there is a such a thing as a paper profit, but all losses are real. At least the way they feel is real.
The risk is you. The stock market is highly predictable because over a long time the sum of all businesses is highly predictable. Around 10% total return. You however, don’t tend to diversify so you are not acquiring the idea of “all businesses” and for many of us the long term is lunch on Friday.
If you look too often you trigger weak responses. If you don’t diversify you narrow choices to something particular and that can include much more risk of real and permanent losses.
An idea to notice.
In 2017 Morgan Housel proposed that there be a book.
I think that book would be a worthy addition to anyone’s financial library with a single amendment. It’s title should be “Start Early Then Shut Up And Wait”
I am willing to listen to reasoned argument about why it should not be so.
I help people understand and manage risk and other financial issues. To help them achieve and exceed their goals, I use tax efficiencies and design advantages. The result: more security, more efficient income, larger and more liquid estates.
Please be in touch if I can help you. don@moneyfyi.com 705-927-4770
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